Ramey
Corporation is a diversified public company with nationwide interests in
commercial real estate development, banking, copper mining, and metal
fabrication. The company has offices and operating locations in major cities throughout
Canada. With corporate headquarters located in a metropolitan area of a western
province, company executives must travel extensively to stay connected with the
various phases of operations. In order to make business travel more efficient
to areas that are not adequately served by commercial airlines, corporate
management is currently evaluating the feasibility of acquiring a business
aircraft that can be used by Ramey executives. Proposals for either leasing or
purchasing a suitable aircraft have been analyzed, and the leasing proposal was
considered more desirable. The proposed lease agreement involves a twin-engine
turboprop Viking that has a fair value of $1 million. This plane would be
leased for a period of 10 years, beginning January 14, 2011. The lease
agreement is cancellable only upon accidental destruction of the plane. An
annual lease payment of $141,780 is due on January 14 of each year, with the
first payment to be made on January 14, 2011. Maintenance operations are
strictly scheduled by the lessor, and Ramey will pay for these services as they
are performed. Estimated annual maintenance costs are $6,900. The lessor will
pay all insurance premiums and local business taxes, which amount to a combined
total of $4,000 annually and are included in the annual lease payment of
$141,780. Upon expiration of the 10-year lease, Ramey can purchase the Viking
for $44,440. The plane’s estimated useful life is 15 years, and its value in
the used plane market is estimated to be $100,000 after 10 years. The residual
value probably will never be less than $75,000 if the engines are overhauled
and maintained as prescribed by the manufacturer. If the purchase option is not
exercised, possession of the plane will revert to the lessor; there is no
provision for renewing the lease agreement beyond its termination on December
31, 2020.
Ramey
can borrow $1 million under a 10-year term loan agreement at an annual interest
rate of 12%. The lessor’s implicit interest rate is not expressly stated in the
lease agreement, but this rate appears to be approximately 8% based on 10 net
rental payments of $137,780 per year and the initial market value of $1 million
for the plane. On January 14, 2011, the present value of all net rental
payments and the purchase option of $44,440 is $886,215 using the 12% interest
rate.
The
present value of all net rental payments and the $44,440 purchase option on
January 14, 2011, is $1,019,061 using the 8% interest rate implicit in the
lease agreement. The financial vice-president of Ramey Corporation has
established that this lease agreement is a financing lease as defined by the
IFRS standards followed by Ramey.
Instructions
(a)
IFRS indicates that the crucial accounting issue is whether the risks and
benefits of ownership are transferred from one party to the other, regardless
of whether ownership is transferred. What is meant by “the risks and benefits
of ownership,” and what factors are general indicators of such a transfer?
(b)
Have the risks and benefits of ownership been transferred in the lease
described above? What evidence is there?
(c)
What is the appropriate amount for Ramey Corporation to recognize for the
leased aircraft on its balance sheet after the lease is signed?
(d)
Independent of your answer in part (c), assume that the annual lease payment is
$141,780 as stated above, that the appropriate capitalized amount for the
leased aircraft is $1 million on January 14, 2011, and that the interest rate
is 9%. How will the lease be reported on the December 31, 2011 balance sheet and
related income statement? (Ignore any income tax implications.)
(a) Benefits
of ownership are the ability to use the asset to generate profits over its
useful life, to benefit from any appreciation in the asset’s value, and to
realize its residual value at the end of its economic life. The risks, on the
other hand, are the exposure to uncertain costs and returns, and to risk of
loss from use or idle capacity and from technological obsolescence.
The IFRS criteria use qualitative factors to
establish whether or not the risks and rewards of ownership are transferred to
the lessee, and supports classification as a finance lease:
1. There is reasonable assurance that the lessee will
obtain ownership of the leased property by the end of the lease term. If there
is a bargain purchase option in the lease, it is assumed that the lessee will
exercise it and obtain ownership of the asset.
2. The lease term is long enough that the lessee will
receive substantially all of the economic benefits that are expected to be
derived from using the leased property over its life.
3. The lease allows the lessor to recover substantially
all of its investment in the leased property and to earn a return on the
investment. Evidence of this is provided if the present value of the minimum
lease payments is close to the fair value of the leased asset.
4. The leased assets are so specialized that, without
major modification at significant cost to the lessor, they are of use only to
the lessee.
No numerical thresholds are applied, as is the case
with PE GAAP, and so the treatment of the lease by the lessee would be the
same, although it would be referred to as a finance lease, rather than a
capital lease.
(b) The conditions of the lease lead us to conclude
that the risks and benefits of ownership have passed from the lessor to the
lessee. Evidence of this includes the bargain purchase option of $44,440
compared to the residual value, which is estimated at $100,000 and will never
fall below $75,000. This fact taken with
the fact that the lease term is 10 of the 15 years of the useful life of the
airplane, it would be foolish for Ramey not to exercise the option to purchase
the plane. Airplanes, when properly maintained, retain their value. Since Ramey
is already paying for the maintenance, it will benefit from this investment in
the increased resale value of the airplane once the bargain purchase option is
exercised. Ramey will consequently benefit from any appreciation in value of
this asset, beyond the term of the lease.
(c) The appropriate amount for the leased aircraft
on Ramey Corporation’s balance sheet after the lease is signed is $1,000,000,
the fair market value of the plane. In this case, fair market value is less
than the present value of the net rental payments plus purchase option
($1,019,061). When this occurs, the asset is recorded at the fair market value.
(d) The leased aircraft will be reflected on Ramey
Corporation’s balance sheet as follows:
Noncurrent assets
Leased property $1,000,000
Less accumulated depreciation 59,300
$ 940,700
Current liabilities
Lease obligation (Note A):
Interest payable $ 74,623
Principal – current portion 60,180
Non-current liabilities
Lease obligation (Note A) $ 802,040
The
following items relating to the leased aircraft will be reflected on Ramey
Corporation’s income statement:
Depreciation expense (Note A) $59,300
Interest expense 74,623*
Maintenance expense 6,900
Insurance and tax expense 4,000
*[($1,000,000 - $137,780) X (9%
X 351/365)]
Note A
The
company leases a Viking turboprop aircraft under a capital lease. The lease
runs until January 14, 2021. The annual lease payment is paid in advance on
January 14 and amounts to $141,780, of which $4,000 is executory costs. The
aircraft is being amortized on the straight-line basis over the economic life
of the asset, estimated as 15 years. The depreciation on the aircraft included
in the current year’s depreciation expense and the accumulated depreciation on
the aircraft amount to $59,300.
Calculations
Depreciation expense:
Capitalized amount $1,000,000
Residual value 75,000
$ 925,000
Economic life 15
years
Annual depreciation $61,667
Depreciation for
the first year prorated to 351 days $59,300
Liability amounts:
Lease liability 1/14/11 $1,000,000
Payment 1/14/11 ($141,780 - $4,000)
137,780
Lease liability 12/31/11 862,220
Reduction of principal 60,180
Non-current liability 12/31/11 $ 802,040
